11 September 2006

Scotia Capital Q3 2006 Bank Review

Scotia Capital, 11 September 2006

Earnings Resilience Continues

Summary and Conclusion

• Banks reported better-than-expected third quarter earnings with growth of 17% year over year (YOY). Bank earnings resilience and momentum has continued to exceed market expectations for the past three years. Retail bank earnings have remained solid and capital markets stellar, with high operating leverage driving wealth management. In addition, loan loss provisions have gone lower than market expectations and have stayed lower longer. Bank trading revenue has also been a very positive contributor to the overall strength in earnings.

• In addition to strong third quarter earnings the quarterly dividend trend continues, with Royal Bank (RY) and Toronto-Dominion Bank (TD) increasing their common dividends by 11% and 9%, respectively. The pattern of dividend increases every second quarter by the individual banks continues. The bank group has now increased its dividends by 176% since the beginning of 2000.

• Bank earnings growth for 2006 is expected to be nearly 15% following growth of 16% in both 2004 and 2005, with 2003 earnings growth at 21%. It appears that 2006 will represent the fourth straight year of significant growth for the bank group. Return on equity in the third quarter was 21.5%, trending at record levels on very large capital positions. As bank earnings climb, the sustainability and quality of these earnings have become a focus.

• Generally we view the quality of earnings as relatively high, with modest reliance on security gains, moderately higher trading revenue, average capital market revenue, tight net interest margins, solid retail loan growth, and trough loan loss provisions. Loan loss provisions in the third quarter were a historical low of 21 basis points (bp), which is the level also expected for the full fiscal year 2006. The trough provisions in this cycle are only slightly lower than the 1988 trough of 23 bp and the 1997 trough of 25 bp. If we exclude net recoveries on the wholesale/other segments for the bank group, provisions would be about 6 bp higher and would result in 2006 earnings levels being an estimated 2.2% lower. If we adjusted earnings for the low level of loan losses and slightly higher trading revenue, bank earnings growth could be trimmed by 3%-4% in 2006. Thus, growth would be in the 11%-13% range versus the forecast level of 15%. This would push the bank P/E multiple up to 13.4x our 2006 earnings estimate versus the unadjusted 13.1x. We view banks at 13.4x (adjusted) essentially trailing earnings, with 20% return on equity as attractive given the long-term growth rates that they have been able to generate and are expected to continue to achieve.

• We expect bank earnings growth to decline to 9% in 2007, which is still a very solid growth rate given the current level of earnings. The market, we believe, is too aggressive in discounting bank earnings for the expected slowdown in growth.

• Bank stocks have had a roller coaster ride thus far in 2006 with a strong rally in the last quarter of 2005 and into early 2006 before correcting through the March to June period. Bank valuation peaked at 15.1x trailing earnings in February before retracing, bottoming at 13.0x in late June. The bank stock correction, we believe, was driven by profit taking, interest rate concerns, and the hot resource and metals sector as banks were used as a source of cash. Bank share price performance has picked up over the past several months, although bank stocks remain vulnerable to bearish market sentiment as they can be readily used as a source of cash.

• However, banks are entering a seasonal period where they have performed exceptionally well over a long period of time. Banks have outperformed the market in Calendar Q4 (October 1 – December 31) 22 out of the past 26 years (Exhibit 2). The four years of underperformance were 1983, 1988, 2001, and 2003. Two of these years, 1983 (Recession, Mexico Default 82) and 2001 (Telco Cable/Power Generation), were caused by major and rapid deterioration in credit quality. We are optimistic that banks will outperform in calendar Q4 and will carry the performance into early 2007.

• We remain overweight the bank group based on record profitability and capital levels, reasonable earnings growth outlook, low earnings volatility, ability to increase dividends, and attractive valuation, including extremely high dividend yields, low P/E multiples, and low relative risk.

• Bank betas remain extremely low with a one-year average bank beta of 0.39, compared with a three-year average bank beta of 0.47 and a five-year average bank beta of 0.81.

• Bank valuation is extremely attractive, especially on a yield basis relative to 10-year bonds, equity markets, income trusts, and pipes and utilities. Bank dividend yields relative to 10-year bonds are now 81%, over 3 standard deviations above the historical mean. Bank dividend yields against the TSX, income trusts, and pipes and utilities are all in the strong Buy range. The market has not paid for the consistent and significant increases in bank dividends. We continue to forecast double-digit dividend growth over the next three to five years.

• The market has revalued bank stocks over the past 20 years on a P/E multiple basis, as it has expanded from 8x-10x to 13x-15x trailing earnings. We continue to believe that a 16x P/E multiple is appropriate given the underlying fundamentals and especially given the level of interest rates. The current P/E multiple of 13.6x trailing or 12.0x 2007 estimates does not fully reflect, in our opinion, the decline in earnings volatility and level of profitability.

• We are increasing our bank share price targets, with our bank index target increasing 9% to 27,000, which is based on a 15.1x target P/E multiple on our 2007 earnings estimates. We were previously using as high as a 15.7x target on 2006E, with our target P/E multiple declining to 15.1x on 2006E based on upward earnings revisions, and we used the upward revisions to put a cushion in for earnings risk (although relatively modest) and slowing earnings growth. Our use of a 15.1x target multiple continues to place a 6% cushion on our 2007 earnings estimates. Our share price target increases are highlighted in Exhibit 1 and provide an expected total return of 29% which is aggressive in this very uncertain equity market but we believe attainable. A hard economic landing would trim absolute returns but relative returns, in our view, would remain attractive.

• In terms of bank stock selection, we continue to focus on the banks that have the strongest profitability, capital and operating platforms, and best growth opportunities, especially given the significant convergence of bank P/E multiples. Individual bank P/E multiples have converged to historically low levels only occurring a few times since 1970. On a long-term basis three banks stocks have significantly outperformed: RY, Bank of Nova Scotia (BNS) and TD.

• We maintain a 1-Sector Outperform rating on RY as we expect its valuations to expand to P/E multiple premiums in the 10%-15% range over the next several years based on fundamentals. RY has above-average profitability and extremely strong operating platforms in retail, wealth management, and capital markets, with no meaningful valuation premium.

• We maintain a 2-Sector Perform rating on TD, Canadian Western Bank (CWB), National Bank (NA) and Laurentian Bank (LB), with a 3-Sector Underperform rating on Canadian Imperial Bank (CM) and Bank of Montreal (BMO). We continue to expect TD’s P/E multiple to expand to a premium as well over time, but dilution from TD Banknorth and weakness in its wholesale bank operations may cause resistance in the near term.

• We maintain our 3-Sector Underperform rating on CM based on continued concerns about revenue erosion, retail market share declines, and relative weakness in wholesale banking. We view BMO as the most overvalued banks stock given its lower earnings growth outlook and lowest profitability of the bank group. The market is paying an embedded premium for BMO’s superior historical credit performance, anticipating a major credit crunch. We believe this premium is too high, especially given the structural changes in the bank group’s balance sheets as leverage to credit has declined four- or five-fold since the early 1980s.

• Our 12-month share price targets on BMO, CM, CWB, LB, NA, RY and TD are $75, $95, $55, $36, $75, $64 and $78, respectively.

Third Quarter Earnings Highlights

Third Quarter Earnings Growth 17%, Exceeding Expectations

• The bank group reported a 17% increase in operating earnings YOY and 5% sequentially. Third quarter earnings were led by RY with 20% earnings growth, followed by BMO at 18%, TD and CM both at 16%, BNS at 14%, with National Bank (NA) trailing at 6%.

• In terms of the small capital banks, CWB’s earnings growth was 20%, led by loan and deposit growth of 25%. LB’s earnings continue to recover, although growth slowed to 15%.

• Third quarter earnings performance was driven by stellar performance from wholesale banking, including strong trading revenue. Wealth management earnings continue to be strong, with retail earnings solid but growth mixed among the banks. The major positive in retail banking this quarter was a 2 bp sequential improvement in the net interest margin (NIM), the best quarterly improvement since rate compression began in 2001. TD and BMO led retail NIM expansion at 10 bp and 7 bp, respectively, followed by RY at 4 bp and NA at 3 bp. BNS and CM reported margin declines of 7 bp and 2 bp, respectively. BNS stated the underlying NIM was unchanged.

Retail and Wealth Management – Earnings Growth Mixed

• Domestic retail and wealth management earnings were solid in the quarter with a growth rate of 11%, although performance varied considerably. TD led with amazing 22% growth, followed by CM at 12% and RY and BMO at 9%. RY growth was hampered by weak insurance results and would have increased 21% excluding Global Insurance earnings. BNS and NA trailed, particularly BNS with no growth and NA up only 7%.

Wealth Management – High Revenue Growth – Earnings Driver

• Wealth management continued to be the major earnings driver in the third quarter. Only three banks (BMO, NA, and TD) currently segment these earnings.

• Earnings growth from domestic wealth management at TD, BMO, and NA was extremely strong at 33%, 21%, and 17%, respectively. Domestic wealth management revenue growth was strong at RY at 21%, TD at 15%, BMO at 14%, with NA growth slowing to 3% from 7% in the previous quarter. Mutual fund assets for the bank group increased 12% to $219 billion, led by RY with 20% growth, BMO 17%, TD 12%, CM 3%, NA 2%, with BNS down 1%. RY is the dominant bank in the mutual fund business, with BMO and TD also strong.

International Divisions

• Mixed results were recorded in the bank group’s non-Canadian business units, with RBC earnings increasing 32%, followed by BNS at 15%, with no growth at BMO and a slight earnings decline at TD Banknorth with TD Ameritrade earnings strong.

• International Banking earnings at BNS in the third quarter increased 15% YOY to $237 million but declined from the record $270 million in the previous quarter. International represented 28% of earnings from operations (Mexico, the Caribbean, and Central America).

• RBC U.S. and International Personal & Business earnings increased 32% to $121 million, representing 10% of operating earnings. RBC Centura continues to produce stronger results aided by lower loan loss provisions.

• BMO’s P&C Chicagoland Banking earnings were flat, unchanged year over year at $38 million, representing a very modest 6% of earnings from operations.

• TD’s U.S. Personal and Commercial Banking segment (TD Banknorth) earnings declined slightly to $68 million from $70 million, representing 8% of earnings from operations. TD Ameritrade’s contribution was $55 million, representing 6% of earnings with no comparable data from a year earlier. TD Banknorth and TD Ameritrade combined represented 14% of earnings from operations.

Wholesale Banking Earnings Increase 22%

Strong at BNS, TD and RY; CM Declines

• Wholesale earnings for the bank group increased 22% year over year, led by BNS, TD, and RY, with increases of 39%, 38%, and 31%, respectively. NA and BMO earnings growth was moderate at 11% and 9%, respectively. CM’s wholesale business continues to underperform with earnings declining 8%.

• Wholesale earnings contributed the largest portion of earnings at BNS, representing 33%, followed by BMO at 32%, NA and RY at 28% each, with CM at 26% and TD the lowest at 20%.

• The biggest surprise in the quarter was the strength of TD’s wholesale earnings, which had been weak and volatile. At the same time CM’s negative momentum continued. BNS results were particularly strong despite weak trading revenue. NA’s weak trading revenue caused some underperformance.

Trading Revenue Strength Indicator Slightly Higher – 103%

• Trading revenue for the bank group in the third quarter was $1,414 million, an increase of 9%. Trading revenue declined from $1,547 million in the previous quarter and the record $1,745 million in the first quarter.

• The trading revenue strength indicator (Exhibit 5, Column 10) was solid at 103% of the average of the past eight quarters, led by RY at 122%, and followed by BMO at 114% and CM at 105%. BNS and NA trading revenue was particularly weak at 80% and 81%, respectively. TD trading revenue strength was 91%.

• RY continues to experience the largest improvement in trading revenue with a 43% increase, with BMO up 31%; in contrast NA and BNS's trading revenues declined 37% and 12% YOY, respectively.

Capital Market Revenue Strength Indicator Weak at 93%

• Capital market revenue was $1,950 million, a decline of 4% year over year and down 10% sequentially. The capital market revenue strength indicator (Exhibit 5, Column 11) was weak at 93%, with BNS and RY above average at 104% and 102%, respectively, with weakness at TD and NA at 81% and 86%, respectively.

Market-Sensitive Revenue Weakest Since 1999

• Market-sensitive revenue (which includes trading revenue and capital market revenue) for the bank group represented 19% of total revenue, the lowest since 1999. The market perception of the strength of trading revenue and capital market revenue is much greater than it really is. Trading revenue has grown since 1996 and represented 8% of total revenue versus 7% in 1999. Capital market revenue represented 11% of total revenue in the third quarter, below the mean of 12.5%.

Loan Loss Provisions Remain at Trough Levels

• Loan loss provisions (LLPs) remain low, as they have retreated to lower levels than anticipated by the market, and we expect them to remain lower for longer than market expectations. LLPs were $492 million in the quarter, a decline of 16% from a year earlier due mainly to lower LLPs at CM. LLPs represented 21 bp of loans, which is the level of LLPs expected for fiscal 2006.

• In terms of the individual banks, BMO, NA, and BNS recorded the lowest provisioning at 11 bp, 12 bp, and 14 bp, respectively. CM, TD, and RY were in the higher end at 40 bp, 26 bp, and 18 bp. CM’s larger credit card portfolio accounts for an estimated 9 bp of the higher LLPs with unsecured personal loans representing the remainder.

• We have reduced our loan loss provisions estimate to $1,990 million or 21 bp in 2006 from $2,115 million. This compares to LLPs of $2,076 million in 2005. The reduction in our loan loss provisions forecast in 2006 is based on lower-than-expected LLPs driven by continued recoveries in the third quarter, with consumer loan loss provisions remaining stable. We also have reduced our 2007 LLP forecast to $2,590 million or 27 bp from $2,830 million or 29 bp. The credit environment remains very benign.

Excellent Profitability – RRWA – ROE

• The bank group reported the third-strongest quarter in history (behind Q1/06 and Q2/06) in terms of profitability, with return on risk-weighted assets (RRWA) of 2.03%, only the fourth quarter ever to be over 2.00%.

• TD holds a substantial lead in terms of profitability based on this measure, with RRWA of 2.54%, assisted by its business mix, followed by RY at 2.22%, CM at 1.97%, and BNS at 1.89%, with BMO the significant laggard at 1.65%. We believe that TD’s and RY’s retail and wealth management platforms have a competitive advantage, which is reflected in their higher profitability. However, we believe that TD’s profitability is more at risk due to heavy reliance on TDCT, the inconsistent performance in its wholesale operation, and earnings weakness at TD Banknorth.

• Return on equity for the bank group in the third quarter was strong at 21.5% on extremely high capital levels. CM, RY, and BNS led the bank group in ROE at 24.9% (assisted by high financial leverage), 23.3%, and 21.8%, respectively.